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Amazon: how big can it get?

Amazon surprised the market with its $13.7 billion acquisition of Whole Foods, but as the company extends its reach into new sectors, will antitrust regulators begin to scrutinise its activities more closely?

It’s easy to spend a lot of money in Whole Foods. Just ask Jeff Bezos. On June 16, Amazon announced it had agreed a deal to acquire the grocery chain, which specialises in high-end organic produce, for $13.7 billion, a 27 per cent premium to its stock price.1

Amazon’s CEO was tight-lipped about the reasoning behind the acquisition. In a statement, Bezos said: “Whole Foods is doing an amazing job”, but didn’t elaborate on how it would fit into his Seattle-based corporate empire. Nevertheless, the market appeared confident the deal would benefit Amazon, whose shares rose 2.4 per cent on the day of the announcement.

The ink was barely dry on the Whole Foods offer before Amazon disclosed plans to build up its apparel offering with Prime Wardrobe, a try-before-you-buy service. Shares in bricks-and-mortar clothes retailers duly fell on the news – and analysts anticipate further disruption in the car-parts sector, where Amazon is rapidly building expertise.

Prioritising revenue and market share over profits, Amazon keeps ploughing capital back into its businesses, enabling it to shake up new industries even beyond retail. The company is now a payment service, lender, manufacturer of household goods, fashion brand, film producer, publisher, web-services provider and logistics firm. Not one to rest on his laurels, Bezos is now planning to set up a delivery service to the moon.2

The speed of Amazon’s growth and the breadth of its reach raise a number of questions: what is its overall objective; how do its acquisitions fit into its strategy; and, if Bezos’s beast continues to gobble up its competitors, what are the chances antitrust regulators will move to stop it?

“Amazon’s ambition is to be indispensable – a one-stop shop for everything online – and when you’re indispensable you can charge monopoly prices,” says Giles Parkinson, Global Equities Fund Manager at Aviva Investors. “We all love it for the price and convenience it offers. But some are beginning to wonder whether Amazon will eventually run into antitrust problems if it carries on like this.”

Whole Foods

Although the Whole Foods deal surprised the market, Amazon’s interest in grocery is nothing new – it first trialled its own food-delivery service, AmazonFresh, as long ago as 2007. But it has remained a relatively small part of the company’s overall operation, which demonstrates the unique challenges associated with the online delivery of fresh produce.

Supermarkets have to strike a delicate balance between supply and demand. Because much of the produce they sell is perishable, they need both supply contracts to bring it in and enough customers to buy it before it rots on the shelves. “Online insurgents need to make sure they have both pieces of the puzzle in place before they scale up, otherwise they can begin to lose money very quickly,” says Parkinson.

Amazon is keenly aware of the fate of Webvan, an online grocery business that emerged during the dot-com boom. Webvan was valued at $7.9 billion soon after its initial public offering in 1999, but by 2001 it had filed for bankruptcy after embarking on an overly-ambitious expansion programme.3

Several Webvan executives are now on the team that runs AmazonFresh, and they appear to have learned from their mistakes with the previous enterprise. Since it made its first delivery in Seattle, the Amazon platform has grown gradually and deliberately, conducting pilot tests in other cities in the US and, as of last year, Europe.

But the Whole Foods acquisition is a potential game changer. According to a regulatory filing, Whole Foods’ management actually approached Amazon in the first instance. Under pressure from activist shareholders, Whole Foods executives read a media story suggesting Amazon had previously considered a takeover bid and contacted the company to determine whether it was still interested.

Opportunistic or not, the deal immediately gives Amazon a nationwide chain of bricks-and-mortar shops from which to sell fresh groceries and a loyal customer base to sell them to. More importantly, Amazon will inherit Whole Foods’ network of supply contracts, which will enable it to scale up its grocery operation much more aggressively.

“If Amazon just wanted convenient locations it would have bought Dollar General, which owns far more real estate than Whole Foods,” says Parkinson. “This is about the supply contracts. Amazon will now be able to fill AmazonFresh baskets with Whole Foods goods and divert its produce to the physical shops to avoid wastage. That will enable it to grow much faster.”

The Amazon Effect

Amazon still owns only a small part of the food-retail industry: its share of the market stood at a mere 0.2 per cent prior to the acquisition of Whole Foods, which itself holds about 1.2 per cent, according to consultancy firm GlobalData. And Amazon’s rivals are investing heavily to maintain their lead over internet-based insurgents, becoming so-called multi-channel retailers in the process. In 2016, for example, Wal-Mart acquired Jet.com, an e-commerce start-up, to bolster its online presence.

Nevertheless, Wal-Mart’s share price declined by 4.6 per cent on the day of Amazon’s Whole Foods deal, and other grocery retailers suffered even worse: Kroger Co., for example, fell just over nine per cent on June 16, compounding losses it had suffered the previous day after a disappointing earnings report.4 These movements suggest the market expects Amazon to leverage the acquisition to grab more grocery business from its rivals, even if the precise details of the Whole Foods tie-up are as yet unclear.

Similar trends are evident in the apparel sector. Amazon recently announced a partnership with Nike to sell its sportswear, and its new Prime Wardrobe service is causing consternation among incumbent fashion retailers. Shares in Nordstrom and JC Penney closed down four per cent and five per cent respectively on the day of the announcement.

“The market has taken the opportunity to sell off companies in the retail sectors as Amazon moves in, whether that is grocery or apparel retail,” says David Bucolo, Senior Research Analyst at Aviva Investors. “But this misses the bigger picture. Amazon’s goal is not to become simply a leading food or apparel retailer. Its long-term objective is to provide everything to everyone.”

These wider ambitions are evident in Amazon’s push beyond retail. The company is reportedly mulling a $9 billion bid for Slack, an office-communications app, which would enable it to go toe-to-toe with technology giants Microsoft and Google in the lucrative ‘chat’ technology market.5 Amazon already rivals the other technology giants in the provision of cloud infrastructure, where Amazon Web Services (AWS) is the market leader.

Nervous investors have coined a new term – ‘unAmazonable’ – as they try to seek out companies that are impervious to the Amazon effect. But there are not many. Indeed, such is the concern over Amazon’s tentacular reach, analysts have begun to deliver negative assessments of industries the company has hitherto shown no interest in, simply because it may eventually cast its beady eye in their direction.

A Morgan Stanley research note in June expressed concern about increased risk of disruption to companies in food-service distribution after the Whole Foods deal, even though Amazon has no current capability to move into the industry.6 “Mr. Market is becoming paranoid,” as Parkinson puts it.

Trust and antitrust

Amazon’s rapid growth has led to calls for antitrust regulators to scrutinise the company more closely. During his presidential campaign, Donald Trump said Amazon has a “huge antitrust problem”.7 But even if the president favoured action, antitrust legislation looks ill-equipped to deal with Amazon.

To understand why, you need to look at the company’s unusual business model. Amazon cleaves to a long-term strategy that keeps its margins razor-thin and directs cash back into investments. Morgan Stanley estimates Amazon’s core retail margins were less than 0.5 per cent of its global gross merchandise value of $205 billion in 2015.

Amazon is able to pursue this strategy because shareholders trust that it will pay off over the long term. For now, they are content to forgo lavish dividends so long as the company’s revenues keep growing. Business commentator Matthew Yglesias had this in mind when he described Amazon as “a charitable organization being run by elements of the investment community for the benefit of consumers”.8

But Amazon’s shareholders are not just being altruistic; they have recognised an important truth. For a large technology company, it makes sense to prioritise market share over profits, due to the nature of online platforms. Online platform markets tend to be ‘winner-take-all’, for two reasons.9 The first has to do with ‘network effects’: the more people who use a network the more valuable that network becomes, forming an entry barrier to competitors. Amazon’s customer-review system, which becomes more comprehensive and useful the more people join the site, is a good example.

The second is data. The more data a firm collects on its potential customers, the better it can tailor its services to those customers. Take Amazon’s artificial intelligence-powered Alexa devices, which sit in kitchens or living rooms, learning from customers’ requests and adapting to their preferences. Because they are always plugged in to Amazon’s vast digital warehouse of products and services, the Alexa machines are able to predict what customers want next.

But unlike Amazon’s shareholders, modern US antitrust law fails to recognise the advantages a company can obtain through network effects and control of data flows because it focuses narrowly on profits and pricing. “On these metrics, Amazon does not raise any red flags. It scarcely makes a profit, gives consumers a good deal and holds only a small share of most of the markets it participates in,” says Parkinson.

Dominant position

Current US legal precedent assumes firms are profit-maximising by default. This means it is difficult to prove Amazon’s practice of holding prices low to gobble up market share is anticompetitive, because such a strategy is deemed to be fundamentally irrational. As soon as it raises prices and starts to make a profit again – so the law assumes – newcomers will be able to enter the market and compete.

Similarly, as modern antitrust law tends to focus narrowly on consumer welfare, it considers horizontal integration as the main warning sign of anticompetitive activity. If the two biggest supermarkets joined forces to take a majority share of the food-retail market, for instance, then the merged entity would be able to charge higher prices – clearly bad news for the consumer.

Vertical integration of the kind Amazon practices does not have the same pricing implications, so the rules in this area are more relaxed. But this underestimates the deeper advantages technology companies can derive from the vertical integration of business lines, which enables them to control data streams. AWS provides the internet infrastructure on which many of Amazon’s rivals depend; Netflix, the video-streaming service that is one of the chief competitors to Amazon Video, is powered by Amazon’s cloud service, for example.

As Lina M. Khan wrote in a recent paper for the Yale Law Journal: “By making itself indispensable to e-commerce, Amazon enjoys receiving business from its rivals even as it competes with them. Moreover, Amazon gleans information from these companies as a service provider that it may use to gain a further advantage over them as rivals – enabling it to further entrench its dominant position.”10

Although European antitrust legislation is similar to US law in most respects, EU regulators have shown more willingness than their North American counterparts to crack down on technology companies for engaging in anticompetitive acts. In June 2017, the European Union fined Google €2.42 billion for abusing its dominance as search engine “by giving illegal advantage to own comparison shopping service”.11

The EU also fined Facebook €110 million for providing misleading information during its 2014 takeover of WhatsApp: Facebook told regulators it would not pool user data across the two platforms, then proceeded to do so.12 So far, however, Amazon has avoided the scrutiny of the European watchdog, apart from a minor case involving the terms of e-book publishing contracts.13 There is little evidence this state of affairs will change.

Barriers to entry

“As long as it keeps consumers happy with low prices and ever-better service, it is difficult to see how Amazon’s growth will be challenged in the US,” says Parkinson.

For now, Amazon’s rivals will have to do without any help from the regulators. So how can investors position themselves as the company continues to expand? Bucolo recommends focusing on firms that specialise in services that e-commerce cannot match, such as retailers providing experiences that are difficult to replicate online.

“Home-improvement retail companies like Home Depot attract homebuilders and DIY enthusiasts to come in to the store and collect goods for use the same day, and that’s something that Amazon currently can’t compete with,” says Bucolo.

‘Off-price’ retailers such as TK Maxx (known as TJ Maxx in the US) or Ross Stores have also proved notably resilient in the face of online competition. TK Maxx, for example, has benefited from the rather intangible sense of novelty its stores offer – the ‘treasure hunt’ element of hunting for bargains.

Another option is to identify firms that could partner up with Amazon to realise mutual benefits. Alliances with Bezos’ giant are likely to become increasingly common, with more retailers signing up to Amazon Marketplace, a platform that third parties can use to sell their wares.

“More retailers may eventually throw up their arms and sell through Amazon. There comes a point when Amazon, with its sophisticated logistics operation, offers a better selling proposition for retailers than running their own e-commerce operations,” says Bucolo. “If you can’t beat ‘em, join ‘em.”

One thing is for sure: ignoring Amazon’s presence is not an option, and investors in everything from groceries to clothes to space travel are going to have to develop strategies to deal with the disruption it causes. “Amazon appears to be a business with unlimited resources and appetite – barriers to entry are going to be tested everywhere,” says Parkinson.

13. In May, Amazon agreed to remove ‘parity’ clauses with publishers that forced them to give it terms as good as those they agreed with rival retailers. ‘EU accepts Amazon e-book commitments to settle antitrust case,’ Reuters, May 2017

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at July 10, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/0907/31102017

The following investment professionals contributed to this article

Giles Parkinson

Fund Manager, Global Equities

Main responsibilities

Giles is responsible for the management of our Global Equity Endurance Fund. Prior to joining Aviva Investors, Giles held positions as an analyst at Artemis Investment Management and before that at Newton Investment Management.

Experience and qualifications

Giles holds a BA in History from Durham University and an MPhil in Historical Studies from Cambridge University. He is also a CFA® charterholder.

David Bucolo

Senior research Analyst

Main responsibilities

David is responsible for investment research in the global consumer sectors. He works directly with the global equities portfolio management teams in analysing consumer companies for inclusion in the firm’s equity portfolios. David also works in a cross-asset capacity developing industry thematic research for the equities, fixed income and multi-asset divisions.

Experience and qualifications

Prior to joining Aviva Investors, David was a senior equity analyst at Colorado PERA and was responsible for equity research across the firm’s global equity funds. Before that, David worked in the investment bank of J.P. Morgan working in both equity sales and, previously, investment banking in both the TMT and Consumer sectors. David began his professional career working in accounting and consulting for Arthur Andersen, LLP and later, FPL Associates.
David holds a Master of Business Administration degree from the University of Notre Dame. He is also a CFA® charterholder.